If you scroll down to my usual weekly thoughts, i've been liking the EURNZD short and EURAUD bias of which both have been doing well (AUD more than the NZD). I think it's time to revisit the EURNZD and analyze the underlying justifications for the short bias. Let's first examine the volatility aspect of the currency pair. Because of the interest rate differential between NZD and the EUR, the 'carry' factor of the currency pair puts forward the assumption that downward developments in risk-appetite should drive the EURNZD pair up, as 'carry trades/risk-on' trades unwind, and that volatility for the pair increases, and vice versa in the market environment where risk sentiment is bolstered. The chart above shows the relationship between Global FX Volatility (Orange) and EURNZD 1m vols since 2007. As we can see in general, EURNZD vols tend to trade lower relative to overall FX market volatility. However recently, since the August China-driven market turmoil, EURNZD vols moved higher relatively to global FX volatility. I think this short term dislocation would correct itself, primarily because 1) risk sentiment indicators such as the VIX has retraced from August highs, USDJPY and SP500 have remained to trade northbound 2) The falling commodity price factor directly impacting FX may be assumed to have diminished (see EURNOK here). 3) The macro picture behind the NZD isn't doing too badly 4) Fed Hike is increasingly priced in that the market won't find it surprising unless Fed signals that future trajectory of rate hikes is faster than 'slow and gradual'. Falling volatility, has, and should correlate to lower EURNZD.

'NZD Dairy' News Count Across Time

Despite a large rebound in dairy prices in the New Zealand GDT index, prices have started to fall again, concerning some market participants to the overall outlook for the NZD economy. Despite the argument that dairy prices are important to keep an eye on for the NZD, it's not always a major factor. I have not been in the markets long enough to know if it's just a fad thing to pay attention to recently, but if we examine the news count for 'NZD and Dairy', we've only really seen headlines talking about it in the past couple of years, with comparatively little coverage before. I forgot to screen-capture a chart that overlays the GDT with the EURNZD, but a look at it would show that it is not incredibly a major driver of price movement. Yes, it has caused the current account to deteriorate slightly, but the deficit is not something to worry about significantly, at this point in time, as everyone has figured out that yes, commodity prices have impacted commodity-dollars severely, and that it would be less compelling for a further price fall in the NZD. Additionally, a more interesting development is how the RBNZ is stuck at a position where it's most likely to hold rates at 2.50%, with the odd coin-flip change of a rate cut in December, of which might be one-off, with inflation setting a trough at 0.3% this year in March, expected to pickup as base-effects fall out next year, where CPI is expected to achieve RBNZ's band midpoint of 2.0% in H2 2016, forecast courtesy of BNZ FX Research. The EUR factor of the equation similarly presents a case that should help drive the EUR/NZD rate lower, primarily on the grounds of a strong easing bias from the ECB, which has undoubtedly attracted the thought that the EUR could be a good funding currency for higher yielding currencies (like the NZD!).

The technical picture is also supporting the downside bias, where the pair on the daily chart is currently developing a flag formation, of which is generally considered to be a corrective phase in price, prior to a further break lower as momentum picks up. I have always traded spot, and hence, I still have much to learn about FX derivatives, though to keep things simple as my first shot, the idea here would be to buy a no-touch (up-and-out) barrier option at 1.6650 with an expiry of 1 month, a level of which if the flag successfully confirms further momentum to the downside, should not be returned to. On a 50K Notional, the premium paid would be around 15K, with a possible payout of 36K, giving a risk:reward of around 2.4. The risk reward is standard and isn't amazing but in my opinion is superior to a short in spot. If we traded short on spot, at the break of the flag, say at 1.6350, a conservative stop placement would be above the flag formation, but would be quite wide, at 2.0% away from the assumed breakout price. To achieve a similar risk:reward, you would need price to drop 4.0% further lower at least for a 2.0 Risk:Reward ratio. From the two, I think that even with the bearish bias for the pair, there is a higher probability for the pair to not touch 1.6650 in a month's time, then drop an extra 4.0%.

Payoff Diagram for the Option

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